March, 2004:

Lu Dayong, chairman of Nanyang Brothers Tobacco (NBT), was recently arrested by the Independent Commission Against Corruption (ICAC) in Hong Kong. Lu was suspected of involvement in cigarette smuggling.

The news came as a surprise to the industry. Qi Mijia, vice manager of Huangpu division at Shanghai Tobacco (Group) Corp., said: “Lu Dayong is a smart man, hard-working and well-paid. Personally, I don’t believe he would under any circumstances help others smuggle.”

But the fact is that Lu was arrested by ICAC in one of its recent efforts to combat smuggling.

Based on information it had received, ICAC arrested 20 people on February 23, including Lu. Three days later, ICAC announced that the suspects might have been involved in HK$ 116 million (US$ 14 million) worth of cigarette smuggling.

Lu is accused of taking HK$ 11.4 million (US$ 1.4 million) in bribes and helping smugglers obtain cigarette sales quotas. The other 19 arrested include two employees of NBT and board directors members or employees in other five companies.

Shanghai Industrial Investment (Holdings) Co. Ltd (SIIC), a famous red-chip company listed on the Hong Kong Stock Exchange (HK00363), wholly owns NBT. Lu is the managing director and deputy CEO of SIIC. Feng Qiming, spokesman of SIIC, told Caijing on March 8 that “presently Lu is only a suspect and ICAC’s investigation is still underway; no accusation has been made, and the board will not take any actions for now.”

However, on SIIC’s website, Lu Dayong’s name has already been removed from the list of managers. SIIC, whose stock transactions were suspended on February 27, made an announcement confirming Lu’s suspected involvement in “bribery” and suspension of Lu’s positions in all of the group’s companies. On March 1, SIIC’s stock resumed trading, but its price declined more than 10% in 3 days.

According to the ICAC’s investigation report, Lu has taken bribes from at least six smuggling groups since December 2003. For each container of smuggled cigarettes, Lu took bribes between HK$ 18,000 (US$ 2,169) and HK$ 150,000 (US$ 18,072). Altogether Lu was alleged to have taken HK$ 11.4 million (US$ 1.4 million) for helping to smuggle 116 containers of cigarettes. In an effort to hide the transactions, Lu and other suspects registered several companies to receive bribe money.

ICAC found HK$ 2 million (US$ 256,000) in cash and six luxurious watches in Lu’s bank coffer. ICAC suspects that Lu received the cash and watches as bribes.

In the import plan of China National Tobacco Import & Export Corp. (CNTIEC), NBT’s factory in Hong Kong should export only 24,720 units of cigarettes to the domestic market in the first half of 2004. Roughly, one unit of export is worth 4000 yuan (US$ 482) and the total amount is only 100 million yuan (US$ 12 million). Based on the ICAC’s discoveries, the value of cigarettes smuggled in December, January and February alone already exceeded that amount. It is unclear why NBT’s sales system reported no effects from the huge waves of smuggled cigarettes flooding its market.

According to Feng Qiming, most cigarettes produced by NBT’s Hong Kong factory are sold in the mainland market. NBT’s major business with the mainland is the export and sale of its own Double Happiness brand cigarettes. NBT itself cannot export cigarettes made in China or trade other Chinese brands. Therefore, a large number of smuggled cigarettes would have an enormous negative impact on NBT’s legal sales channels in the mainland.

A sales agent of NBT in eastern China told Caijing that under normal procedures, a tobacco company chooses agents following a formal appraisal system. If the tobacco company finds that a sales agent owns smuggled cigarettes, the company will immediately disqualify the agent in order to prevent harmful effects on its normal sales channels. Under such a system, if cigarettes produced by NBT were smuggled into the mainland market, NBT’s representatives in the mainland should have felt the impact and tracked the smuggled cigarettes. But surprisingly, it appears as though NBT did not feel any shock from the huge number of smuggled cigarettes on the market.

ICAC accused Lu of helping smugglers obtain cigarette sales quota and taking bribes in return. The cigarette sales quota is related with NBT’s sales system: NBT gives different sales quota to its partners according to their different qualifications. Since the quota is controlled by NBT itself, there exists the possibility of internal corruption and serious management defects.

Lu, aged 56, has worked in the tobacco industry for more than 35 years, mostly in Shanghai.

Unsurprisingly, Lu’s suspected involvement in this smuggling case has negatively impacted SIIC. SIIC is 58% controlled by Shanghai Industrial Investment Group, a window corporation of Shanghai in Hong Kong and a veteran red-chip company. On March 12, the stock price of SIIC was HK$ 18.45 (US$ 2.22) per share, down 10% from HK$ 20.5 (US$ 2.47) on February 27, when its stock transactions were temporarily suspended.

Feng said that SIIC might release a report in April to better explain the event.